This is the worst bond alternative ever

Low interest rates – and they could get lower – are a big problem in investing today.

Investors are reluctant to put much of their portfolio in bonds or guaranteed investment certificates, and they’re considering alternatives. The worst bond alternative by far is preferred shares.

“Fixed Income returns are modest and may decrease due to stable/declining rates,” a reader said in a recently submitted question. “I have been buying the BMO Laddered Preferred Share Index ETF (ZPR) and Horizons Active Preferred Share ETF (HPR) as an alternative. Pros and cons from your perspective?”

The pros are strong yields of 5.4 per cent for ZPR and 4.8 per cent for HPR. This should be considered reliable income with a tax advantage in taxable accounts due to the dividend tax credit. Bond interest offers less default risk than preferred share dividends, but the shares in these two ETFs are heavily weighted to financially stable financial and utility stocks.

The cons with these two ETFS is that preferred shares won’t limit the damage in a stock market correction, as bonds would. In fact, preferred share ETFs could add to the pain.

Preferred shares used to be known as an investment for widows and orphans – low drama on the price side, with safe dividends. But today’s preferred market is dominated by a type of share called the rate reset preferred, which is highly sensitive to interest rates. Rate resets were designed to adjust dividends higher to offset the effect of rising interest rates. When there’s an expectation of falling rates, as there would quite likely be if the stock market crashed, then rate reset preferreds are going to fall in price on the expectation of lower payouts.

Check out what happened to ZPR and HPR when the stock market tanked last winter. Both fell sharply in price because investors were recalibrating their expectations on interest rates. There’s now a sense that rates are stable, or that they could even dip a little further. In that kind of world, rate resets are less in demand and thus vulnerable to price declines.

Preferred shares and the ETFs that hold them are still worth a look if you want tax-advantaged dividend income, but they’re in no way a bond alternative.